Sri Lanka forex inflows rising: Central Bank

Mar 31, 2012 (LBO) – Sri Lanka’s central bank said there had been a “considerable improvement” in foreign exchange inflows in March 2012, amid a caution that it is domestic monetary policy and not inflows that determines an exchange rate. More than 500 million US dollars in foreign investment is expected in the next few weeks, the Central Bank said in a statement.

Analysts however warn that inflows themselves make no impact on the exchange rate if the underlying credit conditions are not corrected.

Inflow Neutral

Higher inflows would result in higher spending on imports later. Lower inflows (including lower exports) would result in lower spending and lower imports later. Neither will affect the exchange rate, provided underlying monetary policy was complementary.

Last year also there were large inflows, but they failed to prevent a balance of payments crisis.

At the start of Sri Lanka’s current balance of payments crisis, a large portion of a billion dollar sovereign bond was “absorbed” on July 27 by the Central Bank through a largely unsterilized purchase.

LBO’s economics columnist, fuss-budget who warned of the impending balance of payments pressure shortly after the large inflow, pointed out that that the bond would only feed the crisis by keeping interest rates down instead of curing it.

Central bank absorptions of inflows, also by-passes the foreign exchange market, undermining a free float, and simply create fresh rupees in the economy.

In the second half of 2011 the Central Bank continued to make unsterilized purchases of large dollar inflows, giving rupees for more domestic loans and then making sterilized sales of dollars, giving yet more rupees for imports and credit later.

The twin practices intensified pressure on the exchange rate, requiring higher interest rates than would have been necessary to cure it, if the dollars were not absorbed and forex markets were allowed to operate more freely.

Credit

The exchange rate is not dependent on inflows, but on monetary policy which impact commercial bank credit in general and central bank credit (printed money) in particular.

Central bank credit funded loans (especially through sterilized sales of foreign exchange) perpetuates an imbalance in the economy.

To cure the underlying problem in the monetary system, interest rates have to rise, allowing banks to raise more deposits (reducing consumption and imports) to fund credit demand. The Central bank has since raised interest rates and helped the process.

The Central Bank said total net inflows to the Colombo Stock Exchange had amounted to 164.2 US dollars million by March 30 and another 400 million dollars had come in through sale of Treasury bills and bonds so far in 2012, the Central Bank said.

This was in addition to funds already raised by commercial banks to strengthen their capital base.

“Reflecting this trend, the exchange rate appreciated to around 128 rupee per US dollar by March 30 from around 130 rupees a week ago,” the statement said.

“The Central Bank also absorbed a substantial part of such foreign exchange inflows, resulting in the gross official reserves increasing considerably during March 2012.”

Domestic Policy

LBO’s economics columnist says that any improvement on the exchange that came or will come would not be because of inflows but because of an underlying correction in the credit system through more appropriate monetary policy.

“If inflows can cure the problem, a billion dollars in a day would have cured the problem in on July 27. It did not,” fuss-budget says.

“Until this basic principle is understood, this country will continue to have balance of payments crises.

“Operational procedures regarding unsterilized purchases and sterilized sales of foreign exchange by the Central Bank will also have to be overhauled.”

If the Central Bank allowed the inflows to the sold in the market, the rupee would have appreciated more. There can be no ‘free float’ with unsterilized purchases. Unsterilized purchases can however be balanced by unsterilized sales later.

A widening of bank net open positions would also help dollars remain unconverted, giving less rupees for loan making and allowing inflows to match directly with import demand generated earlier.

The central bank also said spending on imports decelerated to 20 percent in January 2012 from 34 percent in December 2011.

“A further deceleration in import growth is expected in response to various policy measures introduced by the Central Bank and the government in February and March 2012.”

The has imposed lending curbs on banks and allowed interest rates to rise.

The government also sharply raised fuel prices recently, to reduce credit taken by state energy utilities.